Why you should care

Beijing’s recent sales of securities are triggering concerns that it might dump U.S. securities for leverage in the ongoing spat with Washington.

By Joe Rennison and Colby Smith

The Daily DoseMAY 27 2019

It was an unnerving piece of data for investors two weeks back, buried halfway down an esoteric spreadsheet released by the U.S. government that tracks how many Treasuries foreign investors buy and sell. China, the largest foreign creditor to the U.S. government with total Treasury holdings in excess of $1.2 trillion, sold $20 billion of securities with a maturity exceeding one year in March, according to U.S. government data. The sales amounted to China’s largest retreat from the market in more than two years.

The move came shortly before tensions over trade between Beijing and Washington heated up again, with the U.S. slapping additional tariffs on the country’s imports, and Chinese officials retaliating with measures of their own. What’s more, the sales could not be explained away by the typical ebb and flow of China’s Treasury holdings that result from managing its large reserves to keep the currency stable.

If China starts dumping its Treasuries, it would cause huge financial instability.

Mark Sobel, former Treasury Department official

The data reignited fears that Beijing may weaponize its holdings as part of the trade war, wreaking havoc with the biggest bond market in the world, pushing interest rates higher and increasing the U.S. government’s cost of borrowing.

“If China starts dumping its Treasuries, it would cause huge financial instability,” says Mark Sobel, a former Treasury Department official who spent nearly four decades at the agency, adding that he considered this an unlikely scenario.

China’s holdings of Treasuries are inextricably linked to the country’s trade with the U.S. China receives dollars in payment for its exports to America, and then needs to invest that money somewhere. The Treasury market has long been China’s destination of choice because the market is not only big enough to host its enormous reserves but it also offers a better return than other supersafe investments. Moreover, China avoids currency fluctuations that could come from selling those dollars to buy other assets.

As a result, China’s Treasury holdings typically dip if its reserves fall. It has also sold Treasuries over the past year to support its beaten-down currency, as tariff talk has intensified. On this occasion, though, neither of those forces appears to have been a factor. To some analysts, it seems as though China simply decided to sell.

“One should take notice of a month of sales during a period when reserves appear to be stable by most indicators,” says Brad Setser, senior fellow at the Council on Foreign Relations and a former Treasury Department official. “It is certainly something that warrants attention.”

While concerns are mounting, investors and analysts are wary of jumping to conclusions. Setser cautioned that the March data is a snapshot and not yet a trend. Moreover, few see any alternative for China, other than remaining invested in Treasuries. The benchmark 10-year Treasury yield is currently 2.42 percent, well above the negative yields on equivalent German and Japanese sovereign bonds and still markedly higher than the 1.03 percent offered on 10-year gilts in the U.K. Other markets are also much smaller than the U.S. Treasury market, meaning they would struggle to digest any inflows from China’s massive holdings.

“Even if this were to be a threat, it’s a very noncredible one,” says Sonal Desai, chief investment officer for fixed income at Franklin Templeton in California. “What else [is China] going to buy?”

Meanwhile, there are few signs that recent bouts of selling by China have pushed U.S. interest rates higher. In the second half of 2011, China ramped up its sales of Treasuries but interest rates dropped too. The 10-year Treasury yield tumbled from a peak of 3.74 percent earlier in the year to 1.88 percent by the year-end, amid a general bout of risk aversion caused by Europe’s sovereign debt crisis.

In 2016, China sought to prop up its currency and sold a net $160 billion of long-term Treasuries, with its holdings hitting the lowest since 2010 in November that year. Ten-year interest rates did rise in the U.S. — from 2.30 percent to 2.44 percent over the course of the year — but that seemed spurred primarily by the election of President Donald Trump, which brought renewed hopes of growth for the economy.

In March this year, during the latest round of selling, the 10-year Treasury yield slipped 30 basis points over the month to 2.41 percent.

Still, few disagree that if China wanted to cause an upset in U.S. interest rates by heavy selling of Treasuries, it probably could. The catch is that it would lead to a revaluation of the country’s own U.S. bonds as it sold.

“China selling its Treasury holdings is a nuclear option, because it will hurt their own portfolio,” says Shawn Matthews, a former Cantor Fitzgerald trading head who launched his own hedge fund, Hondius Capital Management, last year.

“It depends on what the goal is,” says Torsten Slok, chief economist at Deutsche Bank Securities in New York. “If the goal is to disturb the U.S. Treasury market, then they may not care about inflicting self-harm.”